Businessweek Archives

A Groundswell Is Building: Toss The Tax System

May 04, 1997

Economic Viewpoint

A GROUNDSWELL IS BUILDING: TOSS THE TAX SYSTEM

`Our current tax system is complicated and unfair, and it must be eliminated." Only a few years ago, these would have been extremist words associated with tax protesters. Today, it is the jointly penned language of Richard K. Armey (R-Tex.), Majority Leader of the House of Representatives, and Bill Archer (R-Tex.), chairman of the Ways & Means Committee. A large and growing number of fiscal specialists agree.

Archer wants to do away with the income tax and substitute a consumption tax (sales or value-added). Armey advocates a flat-rate income tax.

The Senate Finance Committee is equally disgruntled. Its chairman, William V. Roth (R-Del.), has figured out that the estate tax destroys family-owned businesses and farms--bedrock institutions of our country. The estate tax exemption is a miserly $600,000 and has not been increased for a decade. Roth proposes to raise the exemption to $1 million. Others--including House Speaker Newt Gingrich (R-Ga.)--argue for abolishing the tax altogether.

Jack Kemp's organization, Empower America, is agitating for the elimination of the capital-gains tax. On Apr. 15, he sponsored a tax-cut summit in the Capitol at which various congressional leaders declared war on the tax. Even Fed Chairman and deficit-worrier Alan Greenspan says the capital-gains tax "is a direct tax on the nation's standard of living" and argues that the optimal capital-gains tax rate is zero.

CRYING SHAME. This across-the-board assault on the tax system by policymakers shows a fundamental shift in thinking. The function of a tax system is to raise revenues, not to engineer society. To succeed, the tax system must do its work with the least possible damage to incentives and prosperity. Policymakers now understand that the U.S. tax system fails miserably in this regard. All of the above-mentioned tax-reform proposals represent serious thinking about how to lower the cost of capital and other factors of production.

Until the supply-side revolution, policymakers were preoccupied with the effects of taxes on aggregate demand. Taxation's main impact was considered to be on total demand for goods and services. A tax cut was believed to boost consumer demand and employment, while a tax increase was thought to fight inflation by taking money out of consumers' pockets. Taxation's other impact was held to be on income distribution as a result of progressive tax rates.

Although policymakers occasionally toyed with investment tax credits, investment was thought to be dependent on interest rates. To stimulate inflows, policymakers would attempt to lower interest rates by expanding the money supply. This approach failed with the rising inflation of the 1970s. Supply-side economics brought the insight that marginal tax rates directly impact the cost of capital. A reduction in marginal tax rates makes some investment opportunities profitable that formerly could not return a normal profit after meeting tax and depreciation charges. This fresh perspective opened a more promising avenue for stimulating investment than "easy money."

Before the supply-side revolution, fiscal policy was believed to affect demand only. Now, it is understood that fiscal policy affects relative prices and incentives. Lower tax rates increase the value of future income streams and thus stimulate saving, work, and risk taking. The U.S. tax system was cobbled together at a time when economists had no comprehension of the supply-side effects of fiscal policy. Most economists believed that taxes had no adverse macro effect whatsoever so long as government spent the money it collected, thus maintaining the same level of demand. Whenever tax cuts were a political option, they were justified as a stimulus to consumer spending, and it was believed to make no difference whether the tax cut was a rebate of last year's taxes or a reduction in future tax rates.

A tax system that is based on such extraordinary analytical errors is full of mischief and does considerable damage to savings rates, capital formation, labor productivity, and the competitive position of the U.S. economy. This is especially true now that a global capitalism appears to be rising from the ashes of European, Asian, and Latin American socialism. Archer, Armey, Gingrich, Kemp, Trent Lott (R-Miss.), Roth, and many others are engaged in an effort to construct a totally different tax system that raises revenues with minimum damage to economic output. If they succeed, our tax system will have been brought up-to-date with our economic knowledge.BY PAUL CRAIG ROBERTS